While many hope a Brexit can be avoided, the result is currently too close to call. Helen Morrissey looks at the potential impact of a decision to leave the EU
- The UK referendum on EU membership is expected to be held in June
- If the UK decides to leave a new settlement could take several years to implement
- A short-term deceleration in growth could see the emergence of quantitative easing
The UK referendum on EU membership has cast a shadow over the markets. An in-out referendum on EU membership has been promised by the end of 2017, although it is widely expected to be at the end of June. However, this depends on whether the prime minister can secure agreement to reform proposals at the next summit of EU leaders on 18 February.
While most believe that a Brexit can be avoided there is a high degree of uncertainty and the results of any referendum are likely to be close. The Scottish referendum showed how these things can balance on a knife edge, and lessons have been learned from last year's UK general election that polls cannot be relied upon.
"We are still of the view that the UK will want to avoid potentially weakening trade ties and the foreign direct investment that the country has benefited from," says Hermes Investment Management group chief economist Neil Williams. "There is also the risk of diluting the political relationship we hold with the US. However, should Brexit happen the world will not come to an end but it will be a long drawn out process."
So what would the cost of such a move be? Of course there are savings to be made from not having to contribute to the EU budget. This is estimated at some £8-10bn per year but what of the impact of weaker trade links with what is our main trading partner and ensuing market volatility? In addition a decision to leave the EU not only means unwinding regulation but also putting new regulation in place to reflect the new relationship. This is bound to be a long winded and expensive process.
Research from Axa Investment Management (AXA IM) puts the cost of Brexit at somewhere between 2-7% of gross domestic product (GDP) while a more pessimistic outlook puts the cost somewhere around 14% of GDP. The process of leaving the EU would likely be a slow one. The only real precedent so far is that of Greenland in 1985 – this process took three years from negotiation to departure. Given the fact the UK is much larger, not to mention more entwined in the EU, then we could see any UK exit taking much longer. This could have significant long-term impacts on the market.
In the event of a vote to leave the EU it is likely the UK would see some deceleration of growth. Axa IM senior economist David Page believes this could force the Bank of England to cut interest rates and we could even see a re-emergence of quantitative easing (QE).
"To offset a plausible scale short-term deceleration in growth in the immediate aftermath of a vote to exit the EU, we suspect that the BoE would have to cut the Bank rate and announce further QE," he says. "This would be particularly the case if domestic yields rose in response to exit fears and capital outflow."
He continues: "In the short term we would expect a significant depreciation of sterling in trade weighted terms. While sterling would probably look most stretched relative to the US dollar – as it continued a gradual policy tightening phase – we would expect sterling to depreciate significantly against all major currencies."
Added to this a Brexit could bring difficulties in equity and credit markets, making for challenging times for pension schemes.
Hermes' Williams agrees there are challenging times ahead but adds: "This is precisely the kind of uncertainty we want to avoid."
He continues: "In the event of Brexit we are likely to see equities and the pound being hit but in the short term gilts might see some benefit. However, you have to look at who will buy them, in that a lot of gilts are currently held by overseas investors. I think we could see the BoE being backed into a corner in that they don't want to raise rates if the pound is under pressure but then they don't want to cut rates during a market slowdown. In the event of needing someone to effectively sponsor the gilt market we may see the BoE having to start QE again."
So what can schemes do to navigate the choppy investment waters that a Brexit could bring?
"Speaking hypothetically, there are a few areas where schemes can be proactive," says Hermes' Williams. "We will see initial hits to the pound and equity markets and could also see some erosion in the UK's safe haven status so we might see a move towards gilts, which will be seen as a relatively safe harbour during these times."
He continues: "However, there are areas where we can only be reactive. For instance, businesses will need to deploy the services of more lawyers and accountants to deal with the unwinding and redrafting of contracts. Politically as well we could see massive re-deployment of civil servants to deal with the implementation of any new regime. This could mean environmental issues, for instance, fall further down the agenda, which will have an impact on schemes."
So while the current thinking is that a Brexit can be avoided it is prudent not to rule it out altogether. Should the UK opt to leave the EU we will see challenging conditions while the new relationship is developed and implemented. Schemes would be wise to plan for this eventuality.
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